article 3 months old

Punch Drunk On Treasury Wine?

Australia | Aug 05 2013

-Inventory build strategy questioned
-US commercial cycle may be turning
-Strong lift to Oz high-end sales expected


By Eva Brocklehurst

Treasury Wine Estates ((TWE)) has taken a few hits on the chin recently, none the least being a hefty inventory write-down. Some brokers think the stock may be a little punch drunk and have reviewed its value. After all, the company does have some nice product for which demand is always there. Macquarie put the thesis about some months back that Penfolds was by far the most valuable of the assets and the rest of the brands were just complicating the story. More on that later.

Deutsche Bank took a look at Treasury Wine's inventory recently, assessing the merits of accumulating wine inventory for sale at a later date. That is, seeing whether the price appreciation for vintages of premium wines over several years delivers a return to shareholders if inventory is held back from sale. The trigger for this re-assessment is that non-current inventory has lifted materially over the second half of FY13, driven by an impressive 2012 vintage.

Deutsche Bank's analysis suggests that, in most cases, it is better to sell the wine. Price appreciation in Treasury Wine's premium wines has been insufficient to justify the accumulation of inventory for later use. There are some merits to accumulating inventory in a good year because it can smooth earnings in the event of a bad vintage but, to the broker, this is the process of normal business and should not be a driver of the stock price. To that end, Deutsche Bank retains a Sell rating, given the stock's stretched valuation and poor return profile.

Treasury Wine will write down around $200m in FY13 in inventory and lost revenue. Credit Suisse summed up the initial reaction to the news by noting the decision avoided the issues of strategy, governance, accountability and brand equity. The lack of investor confidence in these issues was expected to put pressure on the share price in the medium term and it did.

Subsequently Citi decided to be more positive, upgrading the stock to Neutral from Sell to incorporate a cyclical upturn in the US wine industry. The Americas business will benefit from a growing shortage of US wine grapes and this should drive Treasury Wine's margin higher, by 970 basis points from a trough in FY14. US commercial wine has the most upside for Treasury Wine, in Citi's opinion. While high end wines are enjoying solid growth, low end wines continue to face intense competition caused by excess supply. For Treasury Wine, this commercial segment accounts for 70-80% of volume, but only 30-40% of earnings. The flagship Penfolds brand – Penfolds Bins, RWT, St Henri and Grange – make up only 0.2% of US volume. While the commercial segment faces current hardship, this is where Citi sees the best opportunity if the wine cycle turns.

Treasury Wine is also the price leader in Australia and is raising prices on higher end wines, while discounting some of the foundation brands such as Wolf Blass and Lindemans to maintain market share. Citi thinks this should continue, and expects the market will be surprised at how strong second half FY13 earnings are. Citi is still not getting carried away. The industry is tough, with more producers, fewer retailers and greater competition for Australian wine. In the US business the fight is still on to retain market share. Moreover, the broker suspects Treasury cannot achieve a return on investment capital above the cost of capital.

Away from the US business, BA-Merrill Lynch has also turned more positive and thinks the high quality of the Australian asset base is not getting enough attention. Sure, Australia has not been flavour of the month for a few years overseas but the broker sees a chance that sales of high quality wines could nearly triple by FY15/16. This should be sustained through Treasury Wine's ability to replenish the higher volume of sales via increased production rates.

Treasury Wine has iconic assets in Australia that are seen as largely irreplaceable. Also, there's little debt on the balance sheet and Merrills lauds the investment strategy to increase the availability of high-end wines via vineyard expansion and inventory build up. This increase in long-term inventory has been achieved via investments made in the past three years. To Merrills this build up is not detrimental. Within a year or two, the broker expects nearly $700m of long-term inventory to underpin the company's ability to sell three times what it currently sells in high-end wines. Merrills estimates that around 90% of Treasury Wine's current earnings are sourced from its Australian wine production capability.

The company is expected to generate $275m more earnings in FY15 than in FY13. All of this growth is expected to be sourced from Australian production. The earnings contribution to the US is expected to grow by around $40m, but this should come from Australian exports. Merrills does not factor in Treasury Wine's US business – US wines for the US market. The current low share price is seen offering a good buying opportunity and the broker stands out on the FNArena database with a $10 price target. Minus this outlier the target range is $4.10 to $5.75.

The softening of the Australian dollar has helped export margins but JP Morgan suspects it has quickly been factored into the share price. The broker also thinks consensus earnings are not properly factoring in the balance sheet expansion required to fund Treasury Wine's luxury wine expansion. The broker thinks this expansion will undermine the valuation over time. This will make the stock look increasingly expensive once rising debt lifts the enterprise value.

Macquarie also does not believe the current strategy is creating value. The business is too big and complicated to be successful. Despite this negative, Macquarie has recently upgraded the rating to Outperform from Neutral. The Penfolds Wine Company is the key and Macquarie thinks creating value out of that business alone is the way to go.

On the FNArena database Treasury Wine has five Sell, one Hold and two Buy ratings. The consensus target price is $5.34, up from $5.20 at the end of July and suggesting 7.8% upside to the last share price.

See also, Treasury Wine's Future Red Or White on July 16 2013

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